Tuesday, February 17, 2009

Danger: Inflation/Stagflation Ahead?

Danger: Inflation/Stagflation Ahead?
© 2009 Bert Whitehead, M.B.A., J.D.

Now that the ‘Stimulus Bill’ is in place, how is the government going to pay for all of these new programs and tax cuts? Anticipating the need for additional funds, the Treasury has already begun to issue more Treasury securities* and has scheduled more auctions. So if the government piles on more debt, does this increase in the money supply mean we are on the brink of hyper-inflation, or a return of the ‘stagflation’ of the 1970’s?

Not necessarily: if our nation’s productivity increases in tandem with the money supply, inflation is not likely. In the ‘70’s we had declining productivity combined with entrenched inflation, and the result of high unemployment and high inflation was dubbed “stagflation.” Normally in the beginning of a recession, there is an increase in productivity since production does not drop as fast as employment. For example, in the last quarter of 2008 productivity rose 3.2% in the nonfarm business sector, as hours fell faster than output.

As new employment is stimulated, the plan is to be able to increase productivity simultaneously. There is some concern that, since the jobs initially funded will all be in the public sector, productivity will fall (since productivity only measures business, non-farm business and manufacturing output). Keynesian economics, which is the theory this strategy is based on, projects that the stimulus to the public sector and government spending will ignite private investment and job creation. There is broad disagreement as to whether this worked for FDR in the 1930’s, since the depression didn’t actually end until we entered WW II.

If it doesn’t work, we may well go into a prolonged recession, like the ‘lost decade’ discussed in my last blog. If it does well, the business sector will hopefully recover in a couple of years and start creating new jobs and we will again enjoy prosperity. But government does not create new jobs. If the jobs which are funded are to continue, the government has to keep funding them.

So the danger of inflation will depend on whether we end up becoming dependent on deficit spending. If our economy is worse in 2-3 years, there will be many who will argue that we didn’t spend enough, and insist on increasing government subsidies. This would be aggravated if businesses can’t get back on their feet and unemployment increases. This could produce very painful stagflation.

We don’t know if we face inflation/stagnation, or recession and a dead decade, or reignited prosperity. We don’t do market timing; we seek balance. Our clients are protected by long-term Treasuries if deflation continues. We keep our clients’ positions in equities so when the economy does recover, they will participate in prosperity. So now we are reviewing our client’s portfolios to make sure they will withstand inflation.

Gold and unhedged international mutual funds in the past were bulwarks against inflation. Now gold can be easily traded through ETF’s and so it has become very speculative, which would not be dependable in inflation. Being diversified with international holdings may not be effective since inflation would likely be worldwide.

Having a fixed rate mortgage on your residence is a very effective offset to inflation. Interest rates parallel inflation, so even if you parked the mortgage proceeds in a money market fund, high inflation would raise money market rates. Plus there is an advantage in paying off your mortgage with cheaper dollars.

In recent years, the US Treasury has started issuing ‘TIPS’ (Treasury Inflation Protected Securities). The interest rate on these varies based on the inflation rate. These are not a good replacement for your bond ladder, since they don’t offer protection against deflation. A strong strategy to protect against inflation, if you don’t have a mortgage on your house, is to take out a $300,000 mortgage and use the proceeds to buy TIPS.

Finally we recommend that clients keep an extra cash cushion in this volatile economy. While short term interest rates are low now, cash does provide insurance against higher inflation since interest rates would increase in lock-step. Clients with uncertain job prospects or high expenses looming should maintain additional liquidity. Cash also enables clients to be nimble in these uncertain times and handle unforeseen emergencies without decimating their portfolios.

If you would like to discuss these issues more to see how your portfolio would be affected, feel free to call your Cambridge Advisor for an appointment.

*Treasury Securities include:
Treasury Bills = 1 month – 2 years
Treasury Notes =2 years – 10 years
Treasury Bonds = 10 years – 30 years
This is the only distinction between Treasury bills, notes, and bonds.

1 comment:

John Scherer said...

"We seek balance" - the paragraph about avoiding market timing is great.

Thank you for articulating so well the core concepts of Functional Asset Allocation: protecting against deflation and inflation while positioning to take advantage of prosperity.